iFAST Research Team
WITH the breakthrough of COVID-19 vaccines by various leading drug makers late last year, the growth outlook for US have grown rosier. Not only has daily infection cases plunged sharply, high frequency indicators have also displayed significant improvements. Recent data are also pointing possibly to a faster-than-expected rebound in the US economy.
However, the rosier economic outlook in the US has also introduced inflation worries back into the narrative. Fears that inflation will pick up exponentially ahead, which could inadvertently force the US Federal Reserve (Fed) to tighten rates, have sent markets into a whipsaw last month.
As inflationary fears gripped the markets, the high-growth Tech companies fell the hardest. The elevated valuations of the Tech sector, caused by the massive run-up in stock prices since March last year, has made it a prime target for scrutiny in the recent sessions of sell-off; particularly as investors took profits off their winning positions.
In contrast to the equity market’s latest reaction to rising Treasury bond yields, stocks have consistently rallied through rising rate cycles, with small-cap equities typically the biggest beneficiary. In such a reflationary backdrop, we remain confident that equities will outperform as an asset class.
US economic outlook turning rosier in early 2021
It has been almost a year ago since the COVID-19 pandemic broke out uncontrollably in the US, taking away millions of lives and placing an abrupt end to the decade-long US economic expansion. Since then, the pace of economic recovery has been rather uneven across the globe.
While Asia saw a faster economic recovery amid the superb COVID-19 containment measures, the US (under the Trump administration) has struggled to subdue the virus situation as rate of new infections remained persistently high for much of 2020.
However, with the breakthrough of COVID-19 vaccines by various leading drug makers late last year, the tides have turned. Not only has daily infection cases plunged sharply, high frequency indicators have also displayed improvements across many measures (on the back of the dramatic surprise in retail sales and factory sectors) – pointing possibly to a faster-than-expected rebound in the US economy.
Most importantly, US consumers have displayed promising signs of recovery. The strength and composition of recent retail sales data (specifically tilted towards discretionary categories) suggest that consumers’ aggressive saving patterns are starting to ease – a development in which sustained, could see a release of pent-up demand, shifting the growth of retail sales a gear higher.
This spells positive for the country’s economic recovery as consumer spending is the main engine of growth (personal consumption contributes 70% to gross development product [GDP]).
Further reinforcing the narrative is the trade related data (PMIs and trade volume) and labour market. Optimism among manufacturers has returned steadily, despite short term headwinds placing pressure on the sector’s growth. This comes during a period of rising demand as evident from factory orders as well as backlogs climbs to the highest level since June 2018.
On the labour market front, the job market is displaying nascent signs of things becoming better through the job print despite still treading water – payroll surge past estimates (379,000 vs 200,000 projected) and unemployment rate declines but remains persistently high.
Rising yields and inflation fears send markets into a whipsaw
Lately, inflation has resurfaced as the main concern of the investing world. The rosier economic outlook in the US has also introduced inflation worries back into the narrative. Fears that inflation will pick up exponentially ahead, which could inadvertently force the Fed to tighten rates, have sent markets into a whipsaw last month.
Investors’ concerns are not completely unfounded; after all, inflationary forces are clearly lining up. For one, prices of goods and services have risen significantly across major economies. Commodities, such as copper ores and crude oil – crucial factors of production – have since rebounded above pre-pandemic levels.
In addition, the i) massive US$1.9 tril fiscal stimulus (including handouts to US households) and ii) a weakening dollar have also added to the inflationary woes.
In a recent article, however, we argue that the backdrop for US is likely reflationary, instead of inflationary (broadly speaking, reflation is a recovery in prices to a desirable level spurred on via policy supports, while inflation is a natural rise in prices due to organic growth in the economy).
Regardless, sentiments of market participants began to sour as they weigh inflation risk against the potential impact of the impending fiscal stimulus on US economic growth.
While the improving growth expectations is a positive factor, it also put into question if the loose monetary conditions could continue, given that the Fed may be forced to hike rates to keep inflation under control. For investors, it pays to be cautious; the last time the Fed attempted that in early 2013, a ‘Taper Tantrum’ ensued – leading to a massive spike in market volatility and a hefty correction in global equities thereafter.
This time seems no different. The spike in inflation expectations materialized as a quick chain of market events: (i) a rapid surge in the US 10-year Treasury yields to 1.6% – a level not seen since the start of the pandemic, followed by ii) a broad sell off in the bonds market and ultimately dragged on global equity markets as well – with February extending yet another month of turbulent trading.
High P/E Growth stocks faced the brunt of the rate-driven sell-off
As inflationary fears gripped the markets, the high-growth Tech companies fell the hardest. With the era of cheap money and flush liquidity possibly coming to an end, fundamentals and valuations start to matter to investors again.
Therefore, the elevated valuations of the Tech sector, caused by the massive run-up in stock prices since March last year, has made it a prime target for scrutiny in the recent sessions of sell-off; particularly as investors took profits off their winning positions.
Undeniably, valuations of these growth style equities have become unsavourily expensive – the tech-heavy NASDAQ index’s forward P/E multiple has risen to a peak of 35.0 times in mid-Feb (from 25.0 times in early 2020). In other words, it will take approximately 35 years for the company to earn back the amount paid for each share.
Just as the expansion in valuation multiples was previously justified by the sharp plunge in policy rates (lower discount rates led to higher present values), the opposite is equally true. Such long duration growth assets are naturally more sensitive to changes in the interest rates and hence suffered the most during the recent rate-driven sell-off.
Similarly, the S&P 500 benchmark index also recorded declines during the period, in part due to its high valuation relative to history – albeit more palatable at forward P/E of 22.3 times. Interestingly, gyrations were relatively smaller in this more diversified index: declines in tech sectors is partially offset by gains in the Financial and Industrial sectors (cyclical rotation effect).
While the elevated valuations have been a major draw of US equity markets for much of 2020, we stand to reason that US equities will gradually appear less expensive ahead. As earnings improve off the 2020 low base, we could see P/E valuation multiples contract as the earnings denominator increases.
Strong momentum in earnings recovery across 2021 likely to alleviate valuation concerns
We are starting to see positive signs that earnings of US equities will recover robustly ahead, especially as the economic outlook turn rosier.
In 4Q20, a vast majority (79%) of the S&P 500 companies has reported better-than-expected fourth-quarter earnings results compared to consensus expectations. According to FactSet, 4Q20 marks the third-highest percentage of S&P 500 companies reporting a positive EPS surprise, just behind the record high 84% in prior 2Q20 and 3Q20 quarters. Not only are more companies beating EPS estimates, the magnitude of the earnings surprise (+17.2%) is also well above the 5-year average of +6.3%.
Earnings growth surprises have come from the financials, technology, healthcare, energy and consumer sectors. While growth-oriented communication services (96%) and IT sectors (92%) reported the highest percentage of companies with earnings surprise, the more cyclical sectors like energy (+60.9%), consumer discretionary (+35.3%) and financials (+25.8%) recorded the largest positive earnings beat on aggregate.
More importantly, the fourth quarter earnings season also mark the first time since 4Q 2019 that the quarterly earnings of S&P 500 companies are growing positively quarter-on-quarter basis. We believe in the coming quarters, the rosier macro backdrop and rising earnings expectations could provide an impetus for further positive earnings revisions momentum, given the heavy-handed cuts in EPS estimates last year.
Our optimism in earnings recovery momentum across 2021 is also backed by our belief that the US is in early expansionary phase of the economic cycle. As the US economy reopens and the reflation continues, we expect to see significant improvements in revenue and earnings for the more economic-sensitive industries like transportation, travel and leisure, and restaurants, as well as financial sector where rising loan growth, improving Net Interest Margin (NIM) coupled favourably with lower loan loss provisions to boost bottom-line growth.
At the same time, secular growth-driven sectors like technology and healthcare will continue to benefit from the digitalisation of the economy and accelerating trends (eg remote working, greater emphasis on healthcare innovations) from the COVID-19 pandemic. Furthermore, coattails of positive catalysts are lining up as well: the record US$1.9 tril stimulus, declining COVID-19 case counts/rising vaccination numbers and improving business and consumer sentiments on the gradual reopening of the economy.
Rising inflation expectations causing panic selling? Fret not!
Interestingly, in contrast to the equity market’s latest reaction to rising Treasury bond yields, periods of rising Treasury bond yields tend to be accompanied by above-average performance in the US equities. US stocks have consistently rallied through rising rate cycles, with small-cap equities typically the biggest beneficiary.
Logically, since rising Treasury bond yields serve as a key indicator of inflation expectations and favourable economic growth prospects, surely it bodes well for equities and high yield bonds?
History seems to suggest so. In the periods after the 2008’s Great Recession, there are four distinct upswings in Treasury bond yields: (i) Dec 2008-April 2010, (ii) Oct 2010-Feb 2011, (iii) Jul 2012-Dec 2013 and (iv) July 2016-Oct 2018 – during which US equity markets have registered positive monthly returns on aggregate. In fact, the opposite is true: markets recorded below-average performance on sharp downturn by Treasury yields.
Taking a step back, we opine that focusing on changes in directions and pace of yields is a fool’s errand.
After all, historical analysis also suggest that valuations do not reliably depend on changes in rates. Instead, we prefer to consider the bigger macro picture, characterised by ultra-low rates, tight credit spreads, and recovery in economic activities. In such a reflationary backdrop, we remain confident that equities will outperform as an asset class.
While equity market gains have largely been driven by P/E multiple expansion in 2020, we are now in the early expansionary phase of the economic cycle where the robust earnings growth will hold key in driving future equity market gains this year.
In the near-horizon, it remains an open question as to how long investors’ attention span on the rising longer-dated Treasury yields could hold ahead. But if history serve as any reference, the fickle-minded markets will soon be desensitised by movements in Treasury yields, and the surge in inflationary fears is likely to pass as a fad. – April 16, 2021
iFAST Capital Sdn Bhd provides a comprehensive range of services such as assisting in dealing, investment administration, research support, IT services and backroom functions to financial planners.
The views expressed are solely of the author and do not necessarily reflect those of Focus Malaysia.
Photo credit: Getty Images
